Scapegoating ETFs

It is a longstanding tradition to blame short sellers for stock market debacles (or for individual stock plunges in value). Now, a study argues that ETFs are threatening the economy, manipulate the market and were a cause of the the Flash Crash of May 6. Yup, that's right: ETFs are bad! Or is there another motive for the report?

The report, called, Choking the Recovery: Why New Growth Companies Aren't Going Public and Unrecognized Risks of Future Market Disruptions, declares that ETFs are killing the IPOs of small-company stocks. The report also says that since ETFs are easily shorted, the shorts could put stocks into a "free fall."

In a press release, Bradley and Litan argue: "A form of indexed securities known as 'exchange traded funds'—or ETFs—are distorting the markets to such an extent that they are threatening the growth of new companies by effectively curtailing their access to capital, according to a provocative new report issued today by Harold Bradley and Robert Litan of the Kauffman Foundation. Moreover, it is these derivatives and not the phenomenon known as high-frequency trading (HFT)—commonly critiqued as contributing to the “flash crash” of May 6, 2010—that pose serious threats to market stability in the future."

And says Bradley: “ETFs are radically changing the markets, to the point where they, and not the trading of the underlying securities, are effectively setting the prices of stocks of smaller capitalization companies, or the potential new growth companies of the future,” says Bradley.

Co-author Harold Bradley is the chief investment officer for the Ewing Marion Kauffman Foundation, heading up a team that oversees a $1.7 billion globally diversified, multi-asset class portfolio; Robert Litan is vice president of research and policy for the foundation. In short, ETFs may be eating into their management fees.

Here is why their report is popycock: ETFs are simply too small to affect Russell 2000 ETFs (the Russell 2000 is a popular index for small-company stocks). "Analysts and asset managers specializing in ETFs say the authors don't understand what's going on underneath the hood of ETFs and are scapegoating a product that only makes up a drop in a sea of trillions invested in the market."

For one, ETFs are very transparent; two, they don't buy the underlying security included in the ETF, and, three, you can't cause a short squeeze (and therefore drive an ETF's value higher) because ETFs can create an unlimited number of shares can be created to meet market demand.